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Government and economic growth: Does size matter?

5  Not only size matters

The theory and evidence summarised in this paper suggest that governments can undermine economic growth if they become too large. There is strong evidence that taxes reduce economic growth through their negative impact on incentives to work, save and invest. The provision of public services may also drag down growth if public sector productivity is lower than in the private sector.

However, theory and evidence also reinforces that the impact of the level of expenditure or revenue on growth is dependent on the mix of expenditure or revenue. The cost of financing a given level of expenditure will depend on the mix and design of taxes, as some taxes have a more negative impact on growth than others. Government also has to balance the economic costs of taxation against the benefits of expenditure. Much expenditure contributes to economic growth and government spending also advances social and distributional objectives.

Studies suggest that the greatest economic benefits come from financing reductions in the most distortionary forms of taxation with cuts in expenditures that are unlikely to contribute to growth. However, there is still considerable uncertainty around what expenditures enable economic growth and as to the magnitude of the economic growth benefits from changes to the level and mix of expenditure or revenue. In addition, it is not just the type of expenditure that matters but also its quality - its effectiveness at advancing government's objectives and its efficiency in minimising the cost of delivering public goods and services.

Given the importance of the type and quality of expenditure, it is difficult to draw firm conclusions about the scope for changes in the ‘size' of New Zealand's government from the type of high-level analysis in this paper. That requires more detailed ‘bottom-up' analysis of the costs and benefits of expenditure programmes. Such an analysis should extend beyond growth to include the wider objectives of government, such as advancing living standards and achieving distributional objectives.[20] However, some evidence suggests there may be scope for New Zealand to improve economic growth by reducing or limiting growth in expenditures that do not measurably contribute to raising economic growth and by continuing to improve the efficiency of the tax system.

The share of New Zealand's total government expenditure in GDP has increased significantly in recent years, composed mainly of increases in central government expenditure. Expenditure has been increasing more quickly than in our OECD counterparts, largely closing the gap with the OECD average. While some of this growth has been in areas that may be supportive of economic growth, more than half of core Crown expenditure is likely to be non-growth enhancing and (until recently) it has been growing at a faster rate than GDP. As recent empirical analysis suggests that the benefits of growth-enhancing expenditure may on average be somewhat outweighed by the costs of taxation in OECD countries, the growth benefits may be greater from reducing total expenditure than from shifting resources to more growth-enhancing areas. There are also a number of economic imperatives driving a need for fiscal consolidation in New Zealand to lift national savings and manage our vulnerabilities, while creating the conditions for more balanced growth (see Treasury, 2010a and Savings Working Group, 2011).

Government objectives do extend beyond growth to wider living standards and distributional issues. There are a number of medium-term pressures on government expenditure from rising expectations, demographics, and higher public sector cost pressures. Given these pressures, reducing the share of public expenditure in GDP may mean cuts in the quantity or quality of public services and government will face difficult policy choices even in maintaining the current size of government. Despite these challenges, both existing expenditure programmes and new proposals need to meet a high burden of proof that their contribution to government's priorities outweighs the cost of financing them. This reinforces the importance of incentivising and enabling government agencies to seek continuous improvements in the efficiency and effectiveness of their expenditure. It is critical to identifying opportunities to reduce expenditure, and the associated tax burden, in ways that lift the living standards of New Zealanders.

Notes

  • [20]A forthcoming Treasury Paper will present a descriptive framework of the factors that the Treasury considers comprise living standards, of which economic growth is only one, albeit important, dimension.
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